Capital preservation

Investing is not as complex as most in the field like to make it out to be.  Economists, financial planners, market strategists, professors of finance and economics, etc. like to make the field seem more difficult to grasp than it is.  Not surprisingly, this serves their interests.

In the Middle Ages, when hardly anyone could read or understand Latin, men of the church had a stranglehold on religious doctrine.  If you wanted to understand or get guidance on the most important issues of the time, you had to go through the men of the church.  This served the church’s interests well.

And, so it is now with investing.  Today’s clergymen of finance work hard to cloak the simplicity of investing in higher math, floating abstractions, mindless charts, confusing terms.  Their efforts are not to clarify, but to obfuscate; for, if you’re completely confused, then you’ll need their help! 

(As an amusing aside: a former investing boss of mine, in criticizing my writing ability, complained that I wasn’t writing in a sufficiently high-minded way.  He told me that magazines and newspapers were written at an 8th grade level, and so was my writing, but he wanted it at an 11th or 12th grade level.  When I commented that it might make the writing unintelligible to many of his clients, he said that was okay because his clients would prefer someone who sounded smart over actually understanding!) 

So, why do I claim that investing is simple?  I read a description of investing 16 years ago that made perfect sense and was simple, and I’ve used it ever since.  This description, from Benjamin Graham and David Dodd’s Security Analysis, 1934:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.  Operations not meeting these requirements are speculative.”

No mention of alpha, beta, standard deviation, diversification, macro-economic forecasting, the efficient frontier, small cap blend, negative correlation, optimized portfolios.  You’re investing if you 1) do thorough analysis, and 2) invest in securities that promise a) safety of principal and b) a satisfactory return. 

If you don’t do thorough analysis or hire someone who doesn’t, it’s not investing, it’s speculation.  No stock tips, no hunches, no astrology, no gut feel, no “I just know…”, no buying lots of everything–just thorough analysis.

If you invest in securities that don’t promise–first–safety of principal and–second–a  satisfactory return, then you’re not investing, you’re speculating.  A lot of investors focus on that second part, the satisfactory return part, but few put the emphasis necessary on the first part (which Graham and Dodd correctly made primary).

Many financial planners and investment advisors give lip service to safety of principal, or capital preservation, but few give it the attention it needs.  This lip service to capital preservation is frequently waved away with the magic of diversification.  If you put your eggs in many baskets, they say, then there’s no way all your eggs will break at once.

2008, or any other financial crisis in history for that matter, should put that notion to rest.  Unfortunately, it hasn’t.  Putting your eggs in poorly built baskets, no matter how many of them, is unwise.

Capital preservation is also framed in terms of volatility.  If the basket goes up and down a lot, they say, you’ll get scared.  Fear is a relevant issue, but it’s not the same as capital preservation.  Capital preservation is whether the eggs break or remain whole, not whether they are jostled or swung about.

Capital preservation means you get back what you put in.  Not volatility, not fear, but whether you get back what you put in.  The price of an investment may go up and down and all over, but it’s still capital preservation if you get back what you put in. 

Risk, as Graham defined it, is the permanent loss of capital.  Not the temporary loss of capital, not the fear of the loss of capital, but the permanent loss of capital.  Not eggs jostled or raised and lowered, but eggs BROKEN.

If your investment returns the capital you put in, then capital has been preserved.  If not, or if the safety of that capital, upon thorough analysis, is suspect, then it’s not investing.

This raises an important issue which many overlook: capital preservation is preservation of the spending power of the capital.  Not the capital quoted in dollars, drachma, cows, or shells, but the real, sustainable purchasing power of that capital.  If you put in 6 large eggs and get back 6 small ones, or if even 1 is missing, then it’s not capital preservation. 

Many incorrectly think of cash or bonds as being the soundest means of capital preservation.  In most cases it is, but not if inflation occurs.  If inflation is a real threat over the time-frame that capital must be used, then capital preservation must necessarily include inflation protection.  Cash and bonds, by themselves, don’t cut it.

Most investing experts focus too much on secondary, tertiary, etc., issues.  They focus on diversification, statistical “guarantees,” unexamined impressions, recent history.  But, investing just isn’t that complex. 

You need to do thorough analysis (examine that basket in-depth), you need to preserve capital primarily (will I get back the same number of actual eggs I put in the basket, unbroken), and you’d like to get a satisfactory return secondarily (given that the number and size of eggs is safe, can I get back more eggs than I put in). 

It’s not rocket science or brain surgery–it’s quite simple.

But, as Warren Buffett put it, investing is simple, but not easy.  Which means: knowing how to invest is not complex, but doing it well is difficult.  Losing weight requires you to consumer more calories than you put in–that’s simple.  But doing it isn’t easy–it’s very difficult (especially around Christmas!).

Perhaps Buffett’s investment success should lead investors to focus on his methodology (including very little of what financial clergymen sell), which starts with: capital preservation.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Capital preservation

Measure what matters

Measuring what matters is one of the hardest things to do in life.

Take happiness.  Everyone wants it, but few get it.  Why?  Because most pursue short term pleasures, becoming hedonists, and chase their tail instead of becoming happy.  You have to think long term, and focus on virtue to become happy.  Short term pleasure is the wrong thing to measure; long term virtue is the right thing to measure.

Or, take weight loss.  Almost everyone wishes they weighed less.  But, most fail to lose weight because they try some crash diet they couldn’t possibly stay on over the long term.  The result: they lose a little weight, but put it all back on again because they focused on the wrong measurement–short term scale measurements.  To keep the weight off, you need a long term change of lifestyle–usually less food and more exercise.  You need to measure less food and more exercise over the long term.

But, it’s not easy to measure what matters most.  It’s hard to do and doesn’t give instant results.  C’est la vie!

I run into this all the time with investing.  People want to build long-term wealth, but they try a quick fix instead of measuring what matters most. 

Take, for example. investing in fads.  Many think investing in the latest thing or making a big lottery-style bet is the way to build wealth.  It isn’t, so the vast majority of those who try this approach don’t build wealth.

Or, take index investing.  People hear or read that you can’t beat the market, that low fees matter most, so they jump on the index investing bandwagon (usually after several years where it has worked–too bad we can’t drive by looking in the rear view mirror).  But, paying low fees doesn’t do you any good if the index goes no where for a decade. 

Which brings me to the measure that matter most for investing: after-tax, after-fee returns. 

There’s no benefit to avoiding taxes if you get lousy returns, can invest very limited amounts of money, and pay all kinds of extra fees.  Many 401k and 529 plans exhibit this “benefit.”

Avoiding taxes is not the measure that matters most.  If you can get 10% returns in a tax deferred plan and 10.91% returns in a taxable plan (assuming 33% turnover and 25% marginal tax rate), you end up with the same after-tax money.  That’s right, just find someone who can beat the market by 0.91% over the long run and you might as well save in a taxable account.

This matters because most 401k and 529 plans stove-pipe investors into a few limited options–options that are heavily marketed to make sure lousy money managers can get lots of assets under management.  And that’s before we even get into all the wonderful fees and restrictions that come with such plans. 

There’s no benefit to paying low fees if you get lousy returns, either.  Many investors over-focus on fees.  If you are looking at two options that will generate the same returns, then fees are what matter.  But, that’s a big IF–IF THEY WILL GENERATE THE SAME RETURNS!

If manager A beats the market by 0.5% after fees and index B only charges you 0.25%, you should go with manager A, because your after fee returns are 0.75% better. 

The measure that matters most in investing is after-tax, after-fee returns, not fees by themselves, not tax deferral, not anything else.  Anyone who tries to convince you otherwise is probably selling you something.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Measure what matters

Not so great expectations

If I’ve said it once, I’ve said it a million times: for most investors long term returns are what count most–not what the stock market will do this year or next.

And yet, most investors over-focus on short term prospects.  That’s probably why they get lousy investment results over the long run and brilliantly high (and then low) returns over the short.

It’s not the returns you could have gotten that count, it’s the returns you actually get.

But, long term prospects don’t look that great right now.  By my reckoning, the S&P 500 is set to deliver slightly more than 3% annualized returns over the next 5 years.  With inflation of 1-2%, that’s a real return of only 1-2%. 

Do investors have great expectation when they should have realistic expectations?  I believe so, and they very much want to believe the market commentators who promise 10% returns this year.

Don’t get me wrong, we may see 10% – 20% returns over the next couple of years.  It’s not just possible, it may even be likely! 

But, those returns will be given right back over time.  The market will regress to the mean, as it always does, and investors will once again be right back where they started, or lower.

The way off this treadmill-to-nowhere is to start with realistic expectations and then pick investments that can solidly beat them.  But, this takes time and effort, so most investors prefer the strategy of hope.

Hope, let me be clear, is NOT a strategy (a mantra I learned to repeat from my time in the Air Force).

Can you find investments right now that will beat 1-2% inflation-adjusted returns?  Yes.  Will bonds that yield 3% do it?  Most likely not.  Will stocks of companies with solid franchises, strong balance sheets, reliable cash flow, meaningful dividends, selling at low prices to fundamentals do it?  Most likely.

Will such investments beat the market every month, quarter, or year?  Almost certainly not.  That’s why most people don’t own them!  But, after the market goes up and then down, or down and then up, or sideways for years, or whatever else could happen, such investments will almost certainly win.

Just look for investments in companies that have pricing power–the ability to raise prices with inflation.  That will take care of that nasty 1-2% (or likely more) inflation. 

Then look for businesses that grow with the economy–they sell products or services that people can’t do without.  That will likely give you 3% real returns. 

Then look for businesses that aren’t financed with tons of debt–they are the ones that could go bankrupt in tough times. 

Then, look for businesses that can and do pay out a portion of their earnings in dividends, and make sure they can continue to pay even if business conditions become poor–they are the one’s whose dividends are covered easily by earnings in good times and bad.  That should give you a 2-4% return while you wait for the market to regress to the mean.

Then, make sure you don’t pay too much.  If you pay a high price to fundamentals, you’re doing the same thing as buying the S&P 500 and locking in 1-2% real returns.  If you pay a low price to fundamentals, you’re protected against the downside and likely to benefit from the 1-2% inflation, 3% underlying growth, and 3% dividend specified above. 

If you do all that, you should lock in 6% real returns instead of 1-2%.  That may not blow your hair back, but it’s a lot better than riding the roller coaster up and then down again for the 3rd time in 15 years.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Not so great expectations

Shifting tides

The stock market is frequently looked at as one amorphous whole.  It’s not.

Underneath the calm surface of aggregate stock market statistics are rip-tides of out- and under-performance.  Small companies beating large, value beating growth, foreign beating domestic, bonds beating stocks, commodities beating bonds, etc. 

What seems to surprise investors is how long these trends can last–years, not months.  Looking at 3 or 5 year performance, investors conclude that because foreign has beaten domestic for that long, it must continue.  Just the opposite is the case.

Mean reversion–the tendency of a prices to move back to average–is one of the most powerful forces in finance.  That which has performed best is likely to reverse over the long run.  Just when investors think the tide has gone out, it comes back in.

I believe this is especially the case today.  Specifically, small companies have trounced large over the last five years, bonds have crushed stocks, foreign has crushed U.S., and commodities have crushed…well…almost everything.  But, that which can’t go on forever, won’t.

In particular, I’ve been surprised at how well small has done versus large.  From April 1999 until December 2010, The Russell 2000 (representing small) has beaten the S&P 500 (large) by over 6% a year!  If that doesn’t sound like much, let me rephrase: it’s the difference between no return over 12 years and doubling your money!

Let me clarify: small usually beats large.  Small companies can grow faster and are more nimble, so it’s normal for small to beat large over the long run.  But, the margin is usually a little over 1% a year, not more than 6%.  It’s the difference between having 12% extra money and having over 100% extra. 

Now, this can not last.  And, it won’t.  Regression to the mean will cause large to out-perform small for several years until historical relationships are restored.  I can’t guarantee that, but it’s as close to a sure thing as you can get with investing.

When will the tide come back in?  I don’t know.  I was heavily invested in small companies from 2000 until 2004, so I enjoyed riding the tide out.  From 2004 until now, I’ve been shifting more and more from small to large in anticipation of the sea change.  What has surprised me is that I expected the tide to come in sooner (as it has historically).

Just because the tide seems to be going out more than I thought doesn’t mean I should try to ride it to the last.  Quite the opposite.  The smart thing to do is switch when it becomes prudent and wait for the inevitable.  I’m patiently waiting, and expect to be riding back in to shore soon enough.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Shifting tides